Page 163 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

The concept of cash outflow vs. cash inflows: The following general rules to be followed: Notes

1. Only cash flow is relevant: Cash flow should be differentiated with accounting profits.
2. Estimate cash flows on an incremented basis that follow from project acceptance.
3. Estimate cash flows before interest basis. This is essential since capital budgeting is an
evaluation technique based on discounting future cash flows by cost of capital. Estimate
cash flows on an after tax basis. Some firms do not deduct tax payments.

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Caution While working out cash flows debit or charge in account of interest and cut of
capital should not be considered.

4. They try to offset this mistake by discounting the cash flows before taxes at a rate higher
than the opportunity cost of capital. Unfortunately, there is no reliable formula for making
such adjustments to the discount rate.
5. Do not confuse average with incremental profits: Most managers hesitate to throw good
money after bad e.g., they are reluctant to invest more money in a loosing division. But
occasionally, you will find “turnaround” opportunities in a looser are strongly positive.
6. Cash flows should be recorded only when they occur and not when the work is undertaken
or the liability incurred.
7. Include all incidental effects: It is important to include all incidental effects on the remainder
of the business.

Example: a branch line for a railroad may have negative net inflows when considered
in isolation, but shall be a worthwhile investment when one allows for additional
traffic that it brings to the main line.
8. Include working capital requirements: Most projects require additional investment in
working capital on a continuous basis with increase in sales. This increase in working
capital should be considered as a cash outflow in the relevant period. Similarly, when the
project comes to an end, you can usually recover some of the investment, which will no
longer be required, which will be treated as a cash inflow.
9. Forget sunk costs: They are past and irreversible outflows. Because sunk costs are by
gones, they cannot be affected by the decision to accept or reject the proposal and so they
should be ignored.
10. Include opportunity costs: The cost of a resource may be relevant to the investment
decision even no cash changes hands. For example, suppose a new manufacturing operation
uses land which otherwise could be sold for 10,00,000. This resource has an opportunity
cost, which is the cash it could generate for the company, if the project is not taken up, and
the resource sold or put to some other productive use.
11. Beware of allocated overhead costs: If the amount of overhead changes as a result of the
investment decision, then they are relevant and should be included.
12. Effect of depreciation: Depreciation is a non-cash expense; it is important because it reduces
taxable income. According to the income tax rules in India, depreciation is charged on the
basis of the written down value method at the rates prescribed by Income Tax Rules.
Hence, book profit has to be adjusted by the difference in depreciation (depreciation
charged in books as per Companies Act and depreciation charged as per Income Tax
Rules) to arrive at taxable income. Hence depreciation provides an annual tax shield equal
to the product of depreciation and the marginal tax rate.

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